DC schemes could allocate almost half of assets to illiquids

Maximising the potential of illiquids will, however, require favourable legislation, regulation and guidance, as well as an investment strategy specifically designed to maximise results, the consultancy cautioned.

The report noted that the Australian DC market, which is more mature than its UK equivalent, typically invests around 20 per cent of assets in illiquids, while the Universities Superannuation Scheme, which includes a DC section, invests up to 30 per cent in the space.

Though Nest has committed to investing around 15 per cent of assets in illiquids and Smart Pension currently allocates 10 per cent, across the industry adoption generally has been slim.

“We think illiquid investing is too often placed in the ‘too hard’ or ‘too expensive’ categories, but we could be limiting the ability to improve outcomes for DC savers with this mindset,” the report explained.

As for why this is the case, the report argued that the perception that illiquids are too expensive for DC schemes to invest in has some truth to it, but is not a satisfactory explanation.

Costs and charges are typically higher with illquids than with other asset classes, but these should not be considered alone. Member outcomes must also factor into any analysis.

Despite arguments — not least from the government — that the DC charge cap is prohibitive, “our analysis suggests that charges for the average DC scheme are between 0.3 and 0.4 per cent, despite the current charge cap of 0.75 per cent”, the report explained. 

“This means there is plenty of headroom to allocate to more expensive markets. The key is doing so in ways that will improve outcomes for members net of costs and charges.”

The report also pushed back against myths around DC illiquid investments; for instance, that there are no funds available, that daily dealing is a significant impediment, that illiquids will not deliver better long-term outcomes than cheaper alternatives, and that these investments are always onerously complicated.

“In general, we believe the opportunity to enhance outcomes for members is sufficiently material to justify larger allocations and that liquidity risk and daily dealing requirements can be managed effectively,” it continued.

“In reality, we would expect trustees and governance committees to consider their objectives and beliefs, characteristics of each of the specific illiquid investment opportunities, their potential role at different stages of the glide path for members (including in-retirement), and to have regard to any additional governance requirements.”

This could see “ambitious” master trusts allocating up to 40 per cent of assets to illiquids, while the majority would probably make do with a lower proportion — but still higher than it is currently.

Callum Stewart, head of DC investment at Hymans Robertson, said: “A commonly held belief that investing in the illiquids market is too complex and expensive, and could be leading to caution and limiting the chance to improve outcomes for DC savers.

“Instead, more should be done to recognise the opportunities that investing in illiquid assets can bring to DC schemes, with further evolution of the master trust authorisation rules requiring all master trusts to accept incoming transfers of illiquid assets needed to mitigate potential bulk transfer risks.”

While highest conviction schemes could “take full advantage” and allocate up to 40 per cent of default assets in illiquid investments “in the earlier stages of the savings phase”, the norm for the majority of schemes would be “around 20 per cent”, and there are already examples “of master trusts with allocations close to this level”, Stewart continued.

“For master trusts, we would recommend that schemes should be required to accept incoming transfers of illiquid investments in order to maintain their authorisation. This option would remove some of the most extreme risks around liquidity, yet in tandem should increase comfort levels from schemes to invest in illiquid investments, bolstering perception in the market.

“We would urge the DC sector to revaluate their perceptions and challenge pre-existing beliefs for the benefit of members. We also need policymakers and the Pensions Regulator to work harder to break the link between investment strategy development and absolute levels of costs and charges, which doesn’t automatically translate to better outcomes for the member,” he added.